Why I Love to Invest in Online Marketplaces?

One of the themes that has been consistent with our investments over the past few years is that we have invested in a lot of online marketplaces.  When I am looking at a potential investment I am always looking for businesses which can compound revenues and free cashflows over time. While we want to pay a reasonable price for a great business, we also would love to find businesses where the upside far outweighs the downside.  I think online marketplaces often have these characteristics.

What is an Online Marketplace?

I think the best way to think about these businesses is to first think about a shopping mall.  If you own a shopping mall, your job is to bring together both suppliers and consumers in a mutually beneficial way.  Large malls in the real world do this by providing supply in terms of a large and diverse amount of stores in their mall, which then encourages more shoppers to shop there, increasing the demand, which in turn makes the mall more desirable for suppliers, creating a virtuous circle.

So owning a shopping mall can be a great business.  But it has drawbacks.  It costs a lot of money to build and operate a shopping mall.  It also takes a long time for you to build one, and then even more time to build up your tenant base to the point where your return on your investment is worth it.  And even if you build a successful shopping mall, your growth is inherently limited to the physical space available in your mall.  You cannot just continue to add stores forever.  Only by expanding and putting even more capital in can you continue to grow once you’ve reached your capacity.

In addition, while you have a very direct relationship with sellers as the owner of a shopping mall (they are your tenants), your relationship with the buyers is much less direct.  As a result, the buyers’ relationship is still with the seller, and not with you as the operator of the marketplace.  As you don’t own the relationship with the buyers, the sellers could ultimately decide to move and they could take those buyers with them.

These are limitations which potentially do not apply to an online marketplace.

Qualifications for an Online Marketplace

In order to qualify as an online marketplace, I think there are four basic elements which must be present:

1. The business must be multi-sided.  This means it must aggregate both buyers  and sellers without taking on the seller’s role itself.  In other words, the marketplace business is a landlord for sellers, but not a seller itself.
2. The purpose of the marketplace is to facilitate transactions between buyers and sellers. Typically this means exchanging money for a good or a service.
3. The value added by the marketplace is to lower the search costs for both the buyers and the sellers.  A marketplace is not a middleman but connects the buyers and sellers directly and conveniently.
4. Any marketplace must have network effects present.  With each additional user of the marketplace (either buyer or seller) the value of the marketplace to the users increases.

Controlling the Supply Chain

In the past, businesses could be controlled by controlling the supply chain.  If you control all the supply, customers are forced to come to you.  This is still true in many industries where supply is highly concentrated, like telecommunications. However in many other industries, online marketplaces are disrupting and democratizing supply chains and make it much easier for new entrants or smaller businesses to compete. An example would be Etsy, which makes it much easier for a small manufacturer or artistic creator to sell their goods and compete effectively without having to get their goods on the shelves of a large retail store.  In this way Etsy is democratizing many industries which were previously dominated by large retail chains.  Despite all of the bad news that has happened since the start of the Covid Pandemic, one bright spot is the number of new small businesses that have been started. Literally tens of millions of businesses have been started around the world and Etsy has more than its fair share of these new businesses.  Good for the sellers, good for buyers, and also, good for Etsy.

Advantages of an Online Marketplace

The key to a successful online marketplace is the strength of its network effects.  All online marketplaces have some network effects but some are much stronger than others. Facebook is another example of a marketplace which has very strong network effects.  Because Facebook has over 3 billion users on it’s various products, there is a huge pool of people to interact with on Facebook’s platforms. Because of this, suppliers are heavily incentivized to be present on Facebook.  This means creators will post their content there which means there is more content available to Facebook’s users, increasing the value to them.  It also means though that small businesses will want to advertise on FB which is also useful to FB users because they will be fed useful advertisements that they can choose to purchase.  By adding creators and sellers, FB becomes more useful to users and that encourages more users which only reinforces the network. The more value a marketplace creates for its users, the more powerful it’s network effect is.  FB’s network is now so dominant that it would take a large step up in terms of a competitors value add, for them to dislodge FB as the dominant social network in most countries.

Another advantage of an online marketplace over a traditional business is that they can grow exponentially without requiring huge amounts of additional capital.  If you own a shoe store and your shoes become very popular, you will make a lot of money. However you will also need to invest a lot of money into the business to increase your sales.  In order to satisfy the increased demand for your shoes, you are going to have to buy or produce a lot more shoes, and that will cost money. If the demand is so great, you may even have to build new factories and invest in better ways of transporting those shoes.  You’ll also need to invest in larger warehouse space so that you can hold all of the increased inventory of shoes until they are sold.  All of this takes time and makes it difficult to ramp up sales of shoes quickly.  An online marketplace on the other hand can scale exponentially without having to add additional capital.  That’s because the capital is all being provided by the sellers on the marketplace.  As the owner of the marketplace we are just the facilitator.  We are essentially the landlord for the shoe business.  If the shoe business takes off, the owner of the shoe store will do well, but the online marketplace will also do well, and they won’t have to pay an extra cent.  Similarly if a seller goes out of business for whatever reason, that’s not a disaster to a successful marketplace as they can easily replace the seller with someone else.

Another advantage of an online marketplace is it is not limited much by geography.  Whereas a shopping mall is limited to consumers in a nearby area, an online marketplace is pretty much available to almost anyone.  In Winnipeg where I live there is a large shopping centre called St. Vital Mall.  Even though this mall is about a 20 minute drive from where I live, I have not gone there in probably 20 years.  I am outside the radius of potential customers for that shopping mall. Conversely, I recently purchased an item on Etsy where the seller was located in Georgia, the COUNTRY, not the STATE. It was a small family owned business, halfway around the world, but the power of Etsy’s online marketplace made it a more convenient seller for me then a shopping mall 20 minutes away.  There are still businesses where location matters, even for online marketplaces.  It won’t do me much good to know the best pizza place in Georgia or how to order a taxi in New York, as that won’t help me much when I’m located in Winnipeg. Still unlimited geography is a very powerful advantage for many online marketplaces.

Add up all of these advantages and it’s easy to see why some of the biggest online marketplaces are now some the largest companies in the world. Amazon, Google, Facebook, Alibaba, and Tencent are some of the biggest most successful businesses in the world and they have utilized all of the advantages of an online marketplace to the fullest extent possible.  If we can identify these very strong businesses, we can pay a higher price than we would for a more traditional business, and we will still do very well.  That’s why I love these types of businesses and I expect to continue to own them for many years to come.

- Craig White, BA, LL.B., CIM®

Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.